FR – Nov 2014 – L2 – Q2a – Regulatory Framework for Financial Reporting

Explain limitations of accounting ratios in financial statement interpretation for a non-accounting executive.

Question

A non-accountant friend of yours attended a seminar for non-accounting executives on the interpretation of financial statements.

Though he enjoyed the seminar, especially the aspect on the uses of accounting ratios, he strongly believes that they have their limitations.

Required: State and explain the limitations of ratios for the purpose of interpreting financial statements. (5 Marks)

Answer

Heterogeneity of Business Operations: Ratios can be difficult to interpret for companies with diverse operations across various industries, as it’s challenging to find meaningful industry comparisons.
Inconsistent Results: Different sets of ratios may present conflicting views, with one set indicating financial issues and another showing stability, making interpretation less straightforward.
Judgment-Based Analysis: Ratios provide quantitative data, but they require subjective interpretation, often influenced by management assumptions and external economic conditions.
Alternative Accounting Methods: Companies may use different accounting policies, making comparisons unreliable unless adjustments are made to standardize the ratios.
Inflation Effects: Inflation can distort ratios by affecting asset valuations, particularly on the balance sheet, leading to ratios that may not reflect current economic realities.